Straddle and Strangle

As i continue my tryst with options and come across interesting stuff, i make it a point to pen them down. Here are 2 new concepts i came across lately, Straddle and Strangle.

A Straddle is a trading strategy which is implemented by going long a call and long a put simultaneously. The characteristic of both the put and call will be that they both will have the same exercise price and underlying. The trader long the straddle bets that the stock prices will be volatile in the near future thereby giving him the option to exercise either the call (if the prices go up) or the put (if the prices fall down). The trader short the straddle bets that the stock prices will not be much volatile in the near future and hence neither the call nor the put option will be executed.

A typical payoff diagram for the buyer of a straddle is shown below.

 

As you can see in the above graph, the long makes a profit if the value of the underlying stock rises too high of falls too low i.e. the stock is volatile. The profit potential for the buyer of a straddle is very high while the maximum loss he would bear is the sum total of the call and put option.

The payoff for the seller of the straddle is exactly opposite of that of the long (options are zero sum games, remember !!) A typical payoff diagram for the seller of a straddle is shown below.

As you can see in the above graph the short makes a profit if the stock value remains stable and is within a given range. If the options expire without execution then the profit for the short is the value of the call plus the value of the put. However, the potential losses for the seller is unlimited.

A Strangle is similar to a straddle except that the exercise price for the put and call options will be different. Here in this case, the exercise price for the put option will be less than the exercise price for the call option. Because of this difference in the exercise price, the strangler seller has a wider band of price for which he can make a profit. This band is narrower for a straddle seller. See payoff diagram below for the payoff of a strangler buyer.

A strangle seller would have a payoff diagram which would be exactly opposite of that of a strangle buyer.

I would be writing about Bull spreads and Bears spreads in my next post :)

That’s all folks !!

Arbitrage – aka free money !!

 

Arbitrage refers to trading to make riskless profit with no investments.

Consider this example of arbitrage. Stock of ABC trades on both NYSE and NASDAQ. On NYSE it trades at 15$ and on NASDAQ at 17$. This mismatch in the price of the same stock provides the trader with an opportunity to make a riskless profit. The trader will buy the stock on the NYSE at 15$ and simultaneously sell the stock on the NASDAQ at 17$. The trader makes an instant profit of 2$ without any investment/risk. Note that the above transactions are riskless since the trader enters the 2 positions simultaneously.

Pricing mismatches are very rare and even if there are any, the mismatch would be very less to provide any profit considering brokerage fees and transaction costs.

In today’s financial markets where information flows quickly and where so many traders are on the lookout for mispricing, arbitrage opportunities are virtually non existent and even if one exists the pricing mismatch is wiped out immediately. And hence they say, there is nothing called as ‘free money’ !!

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